Options

TM

Options U
Masters
We’ll walk you through a series of lessons designed to teach you about (or refresh your
skills on) some of the more advanced strategies you can use — in a Foolish way, of course.

Lesson 1: Diagonal Calls

Earn a profit while holding on to the added potential for serious capital gains

Lesson 2: Spreads
Bull calls, bear puts, butterflies, and the many species of options spreads

Lesson 3: Bull Call Spreads

Potentially outsized returns from just a small move in the underlying stock

Lesson 4: Bearish Spreads

When you want to go short, it’s important to limit your risk

Lesson 5: Neutral Calendar Spreads

Imagine if Back to the Future had been about options ...

Lesson 6: Synthetic Shorts

A Foolish investor should only go short carefully

Lesson 7: Synthetic Longs

Take a bullish position without spending capital today

Lesson 8: Strangles
Profit if a stock makes a severe move in either direction

Lesson 9: Writing Straddles

Increase your profits on a covered-call strategy with a tame stock

Lesson 10: Buying Straddles

Set yourself up to profit whether a stock goes up or down

Lesson 11: Protective Collars

Protect an existing investment from downside

Lesson 12: Stock Repair

Get out of laggard positions at breakeven

options.fool.com Options U: Masters Motley Fool Options 1

Lesson 1
Diagonal Calls
Earn a profit while holding on to the added potential for serious capital gains
Why Use Diagonal Calls?
◉◉ If you’re mildly bullish on a
stock and want to generate
income from a leveraged
investment.
◉◉ To profit from a range-bound
stock.
◉◉ If your underlying stock is
chosen well, and you’re
handed a little market luck,
you can wake up a year or
two hence with a significantly
in-the-money call option that
effectively costs you nothing.
Foolish Facts to Know
◉◉ A “diagonalized” position
involves two options — one
purchased, one written — that
differ in both expiration date
and strike price.
◉◉ Like a bull call spread, a
diagonal call consists of two
legs: a purchased lower-strike
call and a written higher-strike
call, but with the added twist
that the purchased call expires
as far in the future as possible,
while the written call expires in
the near term.
◉◉ The maximum loss is simply
the cost to set up the position.
◉◉ You’ll need Level 3 or 4 option
trading permission (and a
margin account) to trade
diagonal calls.
2 Motley Fool Options Options U: Masters options.fool.com
You’re already familiar with the
concept of writing a call against an
underlying stock to produce income,
as with a covered call. And you may
be familiar with the bull call spread, in
which you simultaneously purchase
and sell calls with a “spread” between
the strike prices. Think of the diagonal
call, also known as a diagonal call
spread, as the lovely and talented
offspring of the two strategies — one
that allows you to earn a significant
profit while harboring the added
potential for serious capital gains
down the road. And you don’t need
to be more than mildly bullish on the
underlying company.
To set it up, you buy (“buy to open”)
long-term (almost always LEAPS)
in-the-money call options (rather
than purchasing the stock, as with a
covered call) and write (“sell to open”)
a nearer-term call with a higher strike
price; then, provided your underlying
stock and the long-term call option
are chosen well, and the market
cooperates, you seek to repeatedly
write these shorter-term calls with
higher strike prices throughout the
life of your purchased calls. But
be warned: Diagonal calls retain
significant (leveraged) downside if the
underlying stock craters, and because
you own options rather than the stock
(as with a covered call), your interim
losses can be substantial. Still, applied
judiciously, diagonal calls can make
even the largest, lumbering blue chip
look exciting. Let’s start with the
basics.
Diagonal Call vs.
Covered Call:
Maximum Profit
Covered call: Your maximum
profit occurs at any price above
the written call’s strike.
Diagonal call: Your maximum
profit occurs at the written call’s
strike, after which it tapers off,
back toward zero. In fact, it’s
possible for the underlying stock
to rise sufficiently during the
lifespan of the written option so
as to create an overall loss on the
position.
What Is a Diagonal Call?
The general rules for diagonal calls are:
◉◉ The purchased call leverages
the gains on the underlying
stock, while the written call
reduces your overall cost
and increases the leveraged
returns. However, no free
lunches: It does this by
reducing your gains above the
written call strike as compared
with a covered call.
◉◉ Always match the number of
higher-strike calls written with
the number of lower-strike
calls purchased to mitigate the
downside risk exposure of the
written calls.
◉◉ This is not a “set-and-forget”
trade; you need to actively
 manage the short-term written
calls to maximize gains (or
mitigate losses). You may (and
hope to) write multiple short-
term calls throughout the life
of the long-term purchased
call.
◉◉ Ideal candidates are stable
blue-chip stocks that will let
the options strategy do the
heavy lifting for enhanced
returns. I favor big companies
(a market cap of at least $10
billion, preferably at least
$25 billion) with low debt-to-
capital ratios and a history of
strong returns on equity, free
cash flow, and earnings-per-
share growth.
How It Works
To see a diagonal call in action,
suppose you have a stock trading
at $24.50 with the following options
available:
Strike Expiration Option
Price Premium
$20 28 months $8.15
(LEAPS)
$26 2 months $0.95
To set up your diagonal call, you
would purchase (“buy to open”) the
$20 LEAPS, and then write (“sell to
open”) an equal number of the $26
calls. The net cost of the position is
$7.20 per share.
What’s Next: The First
Interim Period
When your written call reaches
expiration in two months, it will
retain only intrinsic value, while the
purchased call will have significant
remaining time value. The stock price
at that time will dictate your follow-up
action.
We can use hypothetical future stock
prices to forecast the purchased call’s
value at this time. Using a Black-
Scholes option-pricing model, which
we’ll cover in more detail later in
Options U, the prices/profits in Table
1 below would exist at short call
expiration.
When your initial written call expires,
there are three possible outcomes:
◉◉ If the stock price is the same
as the written call’s strike, you
earn the maximum profit for
what we’re calling this interim
period. This is because both
the intrinsic value and the time
value of the written option are
zero. (However, in practice, we
would roll the call forward if
the stock price was hovering
around the written call’s strike
price.)
◉◉ If the stock price finishes above
the written call’s strike at
expiration, we still profit, albeit
at a lesser rate the further the
stock climbs. In extreme cases,
the stock price can run so far
that the overall position turns
into a loss. However, we’d most
likely close the position before
ever reaching that point.
◉◉ If the stock price is below
the written call’s strike at its
expiration, we can enter a loss
position fairly quickly. However,
because we still own that
long-term call, we can write
subsequent higher-strike calls
against it to mitigate our loss.
Graphically, we depict the profit
potential of a diagonal call at the top
of page 4.

Table 1
Stock Price Purchased Written Purchased Written Total Interim
at Written Call Call Value at Call Value at Call Profit at Call Profit at Diagonal Return on
Expiration Written Call Written Call Written Call Written Call Call Profit at Investment
Expiration Expiration Expiration Expiration Written Call (ROI)
Expiration
$18 $3.70 $— ($4.45) $0.95 ($3.50) (48.6%)
$20 $4.90 $— ($3.25) $0.95 ($2.30) (32%)
$22 $6.22 $— ($1.93) $0.95 ($0.98) (13.6%)
$24 $7.66 $— ($0.49) $0.95 $0.46 6.3%
$26 $9.18 $— $1.03 $0.95 $1.98 27.5%
$28 $10.78 ($2) $2.63 ($1.05) $1.58 21.9%
$30 $12.44 ($4) $4.29 ($3.05) $1.24 17.2%
$32 $14.16 ($6) $6.01 ($5.05) $0.96 13.3%

options.fool.com Options U: Masters Motley Fool Options 3

Subsequent Steps: How
Diagonal Calls Can Work
Out Really Well
Arguably, the best outcome from a
diagonal call sees the written call
expire worthless, with the stock price
just below the written call strike
at expiration. You get (near) the
maximum profit for the period, and
can then write a new near-term option
at a higher strike (allowing for more
upside appreciation of your underlying
purchased call); then, that call expires
worthless near its strike, after which
you write a third call, and so on.
Circling back to our example, imagine
that in two months, the stock price is
$25.75. Our original $26 written call
expires worthless. Now, the two-month
$27.50 strike calls would sell for about
$0.80 — so we can write these, bringing
our total cash from call writing to
$1.75, and we repeat the waiting game.
This second written leg increases our
total potential return (to 59% if the
stock price ends at the newly written
call strike at expiration), decreases
our lower break-even price, practically
eliminates the potential for an overall
loss if the stock runs away on us, and
still leaves us two years to continue
writing calls.
Thus, it’s possible that you could
completely recover all of the cash you
initially put into the position. If you’re mild comfort when you realize you’re
doing this into a steadily rising market, left with a 26-month LEAP that’s now
on a solid, steady underlying stock,
you can end up with an essentially free you’re unlikely to find prices on new
deep-in-the-money call option, which calls to write that would allow you to
you can sell or exercise at your leisure. profitably exit the position. You’re stuck
What Can Go Wrong?
We’re looking to make some pretty
hefty gains with a diagonal call, but
remember, there are no free lunches!
Those prospective gains come at the
cost of levered downside losses (in
4 Motley Fool Options Options U: Masters options.fool.com
other words, a diagonal call position
suffers more as the stock declines than
does simple stock ownership). Our
profit suffers as the written call rises
in value, versus the capped profit of a
covered call, or the unfettered profit of
simply owning the underlying stock.
This is why we recommend applying
this strategy to big, stalwart blue chips.
Such companies, if you’ve selected well,
will not run away and hide on you.
You also need to pay extra attention
to a diagonal call; if it looks like it’s
going to be well in-the-money, it may
perhaps be better to close early with
a decent profit rather than hoping for
the stock to come back.
Finally, things can become ... pear-
shaped. Imagine our stock fell to $12 at
expiration of the first written call. That
call will expire worthless, providing but
significantly out-of-the-money, and
— either you write a call for income
that will practically lock in a loss (and
hope the stock rises slowly enough
that you see a series of such calls
expire worthless), or you sit with your
now out-of-the-money call and hope
the stock goes back up such that call
writing again becomes profitable. Either
way, when the word “hope” makes it
into your investment thesis, something
has gone wrong.
Closing Early and
Follow-Up Action
We’ll rarely hold our purchased call
all the way to expiration (if we do, it’s
because we’ve had a nicely cooperative
stock and are now well in-the-money).
Most of the time, we’ll “sell to close” our
purchased call, then use that money to
buy back the written call in the event
the stock price has moved significantly
past the written call’s strike — ideally,
this is delayed as long as possible. We’ll
also consider closing the position if the
underlying business has changed.
The Foolish Bottom Line
It’s best to use diagonal calls on steady
blue-chip companies, leveraging their
slow and steady progress to gain
outsized returns. We’ll target attractive
returns-on-investment, while ideally
managing our positions to nurture
and grow a few “free” in-the-money
calls along the way. The lower up-front
investment and potential eye-popping
returns make us willing to shoulder
the leveraged loss potential on the
downside, while ceding some of our
upside gains.
Lesson 2
Spreads
Discover bull calls, bear puts, butterflies, and the many species of options spreads
Why Use Spreads?
◉◉ To profit on the movement
in a stock while capping
your potential loss at a pre-
determined amount — though
you cap your potential profit as
well.
◉◉ To purchase options with less
cash up front, which in turn
helps leverage your potential
returns.
◉◉ To earn sizable percentage
gains even on modest moves in
the underlying stock.
A spread is an option position in which
you both buy (“buy to open”) and write
(“sell to open”) options of the same
type, usually with the same expiration
date, on the same stock. The payment
from the options you write helps offset
the cost of the options you buy, limiting
your initial cost. At the same time, the
options — being opposites, because
they’re both bought and written —
counterbalance one another, capping
your risk.
For example, you might write a call at
one strike price and use the proceeds
to buy a call at a lower strike price
(with the same expiration date, on the
same stock). This is called a “bull call”
spread; your maximum potential profit
is the difference between the strike
prices, minus the net cost to initiate the
trades. Because one option covers the
risk in the other, your maximum loss is
the amount you pay to set up the trade.
options.fool.com Options U: Masters
The name “spreads” refers to the
difference between the two options’
strike prices, which largely determines
your potential profit. But spreads don’t
always use different strike prices, so it
may sometimes refer to the difference
between the two options’ prices.
The Common Spreads
No matter what kind of spread we’re
setting up, usually we’ll aim for at least
a 50% return — ideally, 100% or more
— to make the risk (a full loss of the
investment) worthwhile. Here are some
spreads you’ll encounter most often:
Bull call spread: A bullish strategy
in which you write a call with a
higher strike price (usually above the
underlying stock’s current price) and
buy a call with a lower strike price. You
earn the full potential profit if the stock
increases above the higher strike by
expiration; you lose the full investment
if the stock falls below the lower strike
by expiration.
Bull put spread: A bullish strategy,
though it uses puts; you purchase
lower-strike puts and write higher-
strike puts, for a net credit. If the
stock ends above the higher strike at
expiration, you earn the maximum
profit.
Bear put spread: A bearish strategy
in which you write a put with a lower
strike price (usually below the stock’s
current price) to buy a put with a
higher strike price. You earn the full
profit if the stock declines below
the lower strike by expiration; you
lose your full investment if the stock
increases above the higher strike by
expiration.
Bear call spread: A bearish strategy
that uses calls; you purchase higher-
strike calls and write lower-strike calls,
earning the full profit if the stock ends
below the lower strike at expiration.
Bear put spreads are generally
superior to bear call spreads if you’re
exceptionally bearish, but bear call
spreads are attractive because they start
with a credit and can use less buying
power.
Butterfly spread: This neutral strategy
combines a bull spread with a bear
spread (there are four possible ways
to set it up); you profit most if the
underlying stock does not rise or fall
much by expiration. Like all spreads,
it has limited risk and limited profit
potential.
Calendar spread: A generally neutral
strategy in which you write a nearer-
term option and purchase the same
option (in this case, at the same strike
price) but with a much later expiration
date. Time erosion should cause the
value of the nearer-term option (which
you wrote) to decay more quickly
than the longer-term option that you
bought; if it works as intended, you’ll
show an overall profit as the near-term
option reaches expiration.
Ratio spreads: Also a generally neutral
strategy, here you buy a certain number
of calls (called a ratio call spread) or
puts (called a ratio put spread) and
then write a larger number of calls
Motley Fool Options 5
or puts (say, two for every one you’ve
bought) that are out-of-the money.
Your profit is maximized if the stock
ends exactly at the strike price of the
written options. Ratio spreads have
increased risk because not all of your
written options are “covered” by
purchased options.
We’ll get into these and other spreads in
greater detail in future guides; for now,
we just want you to become familiar
with the many terms and basics behind
spread strategies. And — if you need
to — you can take this opportunity to
apply for approval to use spreads at
your broker (it’s usually Level 4).
Learn the Language
of Spreads
When setting up a spread trade, the
combined premiums are labeled like so:
Debit spread, or net debit: Here, you
pay more in premiums to set up the
spread than you collect.
Credit spread, or net credit: Much
less common than a net debit, in this
case, the spread’s total option premiums
collected pay you more than you need
to pay out. In other words, the options
you write pay you more than you need
to shell out to buy the other options to
complete your spread.
Spread order: This kind of special
order allows you to make two or more
options trades (usually for a lower
commission) with your broker at the
same time — thus setting up your
spread. Usually, the trade is entered as
a limit order at the maximum net debit
you’re willing to pay or the minimum
net credit you want to receive. This
is similar to using a limit price when
trading a stock.
Moreover, spreads can be described
more precisely depending on where the
strike prices and expiration dates fall:
6 Motley Fool Options Options U: Masters options.fool.com
Vertical spreads: The most common
spreads fit this description, including
basic bull and bear spreads. In a vertical
spread, the options have different strike
prices but the same expiration date.
It’s called “vertical” because the strike
prices are above and below one another
in an option-quote chain.
Horizontal spreads: In this case, the
options have the same strike price
(horizontal to one another in a quote
chain) but different expiration dates.
Diagonal spreads: Here, the options
you buy have a later expiration date
than the options you write, along with
a different strike price. You can set up
diagonal bull spreads, diagonal bear
spreads, and diagonal butterfly spreads,
to name a few. We’ll address why and
how in later guides.
Now let’s illustrate what we’ve covered
so far with a real-life (OK, a very fake)
example.
A Vertical Bear Put Spread
in Action
As the result of a questionable federal
government-backed merger, a new
company comes into existence called
Fannie Madoff. Most investors are
optimistic, pointing out that anything
the Fed does, it does well, so they’re
sure the firm will be a success.
But you are fairly certain this house
of cards will topple. The company
has questionable management and
is crippled with debt — yet investors
continue to bid the stock higher. Since
you don’t want to risk your net worth
going short, you set up a bear put
spread, limiting your potential losses.
With the stock trading at $34, to set
up a bear put spread, you could write
$32.50 puts for a $1.50 payment and use
the proceeds to buy $35 puts for $2.50.
Your net debit is $1 per share. That’s
the most you can lose. How much can
you make if Fannie Madoff faces the
music? Since the difference between
your strike prices is $2.50, and the trade
cost you $1, the most you can make is
the difference between the two, or $1.50
per share. That’s great, given that you
only paid $1 to set up the trade. It’s a
potential 150% return.
What are the possible outcomes? If the
stock falls below $32.50 by expiration,
you capture the maximum gain. For
example, let’s say it falls to $30. The
$35 puts you bought will be worth $5
per share, while the $32.50 puts you
wrote will be worth ($2.50). You hold
a net $2.50 profit following your $1 net
investment, so you’ve cleared $1.50 per
share while only risking $1.
On the flipside, if the Fed gives our
fake Fannie another boost, and the
stock is above $35 at expiration, your
whole investment is lost — but at least
you only paid a net $1 per share. Other
possible outcomes: If the stock trades
at various price points between the two
strikes, you’ll have either a partial profit
or partial loss when you exit the trade
at expiration. (When to close a spread
early is a topic for another day.) This is
the essence of how a spread works: You
limit your risk while potentially earning
a large — though capped — percentage
return on a lower out-of-pocket cost.
Spreads Ahead
To sum up, spreads involve both buying
and writing the same type of option on
the same stock, usually with different
strike prices, while aiming to profit
on the difference in strike price, after
your net cost, between the two. Your
maximum profit is capped to these
price differences, and your maximum
loss is the net debit that it takes to set
up the trade. Spreads have numerous
variations, so we’ll enjoy discussing
different ways to set them up, and why,
in future Options U guides.
Lesson 3
Bull Call Spreads
Achieve potentially outsized returns from just a small move in the underlying stock
Why Use Bull Call Spreads?
◉◉ Capital gains: To profit on a
stock you feel relatively bullish
on.
◉◉ Defense: To limit your capital
at risk and lower your break-
even point compared with just
buying calls alone.
◉◉ Leverage: To land an oversized
potential return on your net
cost, although you sacrifice
additional upside.
Foolish Facts to Know
◉◉ Bull call spreads consist of two
legs: You write (“sell to open”)
a call at a higher strike price
and simultaneously buy (“buy
to open”) a call at a lower
strike price. So you’re writing
a call and using the proceeds
to purchase a call on the same
stock, setting up a bullish
position with reduced costs.
◉◉ Your maximum profit is the
difference between the two
strike prices, less the net cost
to set up the spread.
◉◉ Your maximum loss is simply
the cost to set up the position
in the first place.
◉◉ Each call option contract,
bought or written, represents
100 shares of the underlying
stock. Always match the
number of contracts written
options.fool.com Options U: Masters
to the number of contracts
bought.
◉◉ You’ll typically need Level
3 or Level 4 options trading
permission to trade spreads.
Welcome to our first lesson on spreads.
Today’s topic: the bull call spread.
If you’re modestly bullish (or even
somewhat neutral) on a company,
this options strategy can deliver you
potentially outsized (albeit capped)
returns with just a small move in the
underlying stock. Your potential loss
is 100% of the cash you put into the
strategy, but that cost is offset by what
you’re paid for the calls you write.
Bull call spreads strike a good balance
between the advantage of a capped
potential loss and the disadvantage
of capping your potential gain. The
drawback to a capped upside happens
when the underlying stock rockets.
You’ll have to be content with your
profit, though one benefit is that you
can possibly cash out months early
(making your annualized profit pretty
awesome). Now let’s look at how the
bull call spread works.
What Is a Bull Call Spread?
A bull call spread works like so: On
the same underlying stock, you buy
(“buy to open”) a call option and
simultaneously write (“sell to open”) a
call option with a higher strike price,
using the same expiration date. The
purchased call leverages your gains on
the underlying stock. Meanwhile, the
written call pays for much of the cost
of the purchased call and increases
your leveraged returns. However — no
free lunches — the bull call spread
does this at the cost of your potential
upside, which is capped. So, over the
time frame of your options, it’s possible
for the gains in the underlying stock to
surpass the returns on the spread.
A bull call spread is a type of vertical
spread, which is simply any options
strategy in which you simultaneously
buy and write options of the same type
(either calls or puts) with the same
expiration date, but with a “spread”
between the strike prices (hence the
name — clever). We’ll be covering
more of these as we go along, but for
now, back to the bull call spread — and
how to set it up.
Setting Up the Trade
As a general rule, you want to make
sure that the number of higher-strike-
price calls you write always matches the
number of lower-strike-price calls you
buy. This ensures that your downside
risk (represented by the written calls)
is completely covered by the upside
potential of the calls you buy. And
because this is a bullish trade — that
is, you are expecting the stock price to
go up, taking the value of both options
with it — you want to buy as much
time as you can to let your bullish
thesis play out.
For example, suppose you have a
stock trading at $28. The furthest-out
available options expire in just under
Motley Fool Options 7
a year and a half, and calls have the You don’t necessarily need to be wildly, Remember, our stock currently trades
following prices quoted: wantonly bullish — a little dab’ll do at $28. So if you follow the conservative
ya. That’s because spreads can be strategy, you can actually stand to
Strike Price Premium
constructed with varying degrees of watch the stock fall by $3 over the life
$20 $8.50 aggressiveness. Conservative types can of the spread, still make a tidy profit,
$25 $5 buy and sell both of the calls in-the- and still at least recover your capital
$30 $2.50 money (here, strike price = share even if the stock falls by 16% (to $23.50)
$35 $1 price), limiting return but also limiting between now and expiration.
risk. Aggressive folks can buy and write
Setting up a nice, middle-of-the-road But fair warning: It may be fun
both calls out-of-the-money (here,
bull call spread, let’s say you buy (“buy to model bull call spreads with
strike price is higher than share price)
to open”) the $25 strike calls, and then potential returns running hundreds
and put up some spectacular potential
write (“sell to open”) an equal number
returns on paper. Using the stock and of percentage points in less than two
of $30 strike-price calls. The net cost
calls listed above, we can construct bull years, but if the underlying stock has
of the position (before commissions) is
call spread positions tailored to your to rise 50% for you to make big money,
$2.50 per share. You now have about 17
investing style — see Table 2 below. your odds of success are lower. In a
months to watch the movement of the
underlying stock — but absent closing
the strategy early, you have capped
Table 1
both the potential losses and potential Stock Purchased Written Purchased Written Total
gains. Your profits are maximized if Price at Call Call Call Call Spread
the stock price is above the higher Expiration Value at Value at Profit at Profit at Profit at
strike price at expiration, while you Expiration Expiration Expiration Expiration Expiration
risk a 100% loss of capital if the stock $22.50 $0 $0 ($5) $2.50 ($2.50)
finishes below the lower strike price.
$25 $0 $0 ($5) $2.50 ($2.50)
(See Table 1 at right.)
$26 $1 $0 ($4) $2.50 ($1.50)
Both your profits and losses are $27.50 $2.50 $0 ($2.50) $2.50 $0
capped. No matter how low the stock $29 $4 $0 ($1) $2.50 $1.50
price goes, you can’t lose more than
$30 $5 $0 $0 $2.50 $2.50
your original $2.50 per share invested.
No matter how high the stock price $32.50 $7.50 ($2.50) $2.50 $0 $2.50
goes, you can’t make more than $2.50
per share. But that’s not bad, Fools: Table 2
If you bought 10 calls and wrote 10 Metric Conservative Moderate Aggressive
calls, and the stock ended up above
Strike price of $20 $25 $30
the higher strike price at expiration,
purchased call
you’d have an extra $2,500 jingling in
your pockets after 17 months — less Strike price of $25 $30 $35
time than passes between successive written call
Summer and Winter Olympics. Net investment $3.50 $2.50 $1.50
per share
When to Use Bull Call Maximum payoff $5 $5 $5
Spreads per share
Maximum return 43% 100% 233%
When using a bull call spread, your
on investment
outlook on the underlying stock is
bullish — you need a rising stock price Stock price $25 $30 $35
(or at least a flat one, depending on to achieve
how aggressive you make the spread) to maximum profit
achieve your maximum profit. Break-even price $23.50 $27.50 $31.50

8 Motley Fool Options Options U: Masters options.fool.com

baseball parlance, it’s far better to be a
.320 hitter with an outstanding on-base
percentage than a .250-hitting “big
bat” who smacks tape-measure home
runs — but also strikes out half the
time. The latter is a crowd favorite; the
former is a potential hall-of-famer.
Closing Early
If the stock goes up, and we’ve made
most of our potential profit on this
strategy, we’ll close early. Generally,
if the spread, or at least the call we
purchased, is in-the-money (here, strike
options.fool.com Options U: Masters
price is lower than stock price) near
expiration, it’s best to close it ahead of
the final bell and avoid the added cost
(commissions) of it being exercised.
If there’s only 10% of the remaining
profit to be realized, and a year until
expiration, we’re happy to cash out
early and pass out tea and medals.
In less happy times, the underlying
stock won’t cooperate with our bullish
prognostications. In such cases, we’ll
watch the stock closely, and if we
believe the thesis has changed, we’ll
close the spread before expiration, lick
our wounds, and move onto the next
idea.
The Bottom Line
on Bull Call Spreads
We’ll use bull call spreads on stocks we
believe will increase in price at least
moderately. The strategy has a nice
mix of capped risk, lower up-front
investment, and healthy prospective
returns on investment, such that we’re
perfectly happy to cede additional
potential upside in the stock.
Motley Fool Options 9
Lesson 4
Bearish Spreads
When you want to go short, it’s important to limit your risk
Why Use Bearish Spreads?
◉◉ To profit on a falling stock or
index while capping your risk.
◉◉ To earn strong percentage
returns on a moderate move in
an underlying investment.
◉◉ To lower the cost of bearish put
option purchases.
Earlier, we introduced spreads
— specifically bull call spreads
— explaining how they involve
simultaneously buying and writing
the same type of option (either calls
or puts) on a stock, usually with
a “spread” between the two strike
prices. You can set up bullish, bearish,
or neutral spreads, and they can be
defensive or aggressive.
At Motley Fool Options, we’ll likely
use bearish and neutral spreads more
often than bullish spreads. Why?
When you’re bearish and want to go
short, it’s important to limit your risk.
That’s exactly what spreads do —
though they cap your potential profit
in the process. When you’re bullish,
it can pay to have unlimited upside
potential and it’s less important to
limit risk, sometimes making spreads a
less appealing strategy. There are three
key bearish spreads we’ll consider
here, so let’s go over how they work.
Bear Put Spreads
The most common bearish spread
involves buying a higher-strike put
and financing some of the purchase
by writing a lower-strike put with
10 Motley Fool Options Options U: Masters options.fool.com
the same expiration date on the
same underlying stock. The put you
purchase will appreciate in value if
the underlying stock declines. Since
our potential loss is 100% of the
capital we invest, we prefer setting
up bear put spreads that can return
at least 50% to 100%, making the
risk worthwhile. Ideally, we’ll do this
using strike prices that are within
20% of the current share price so
we’re not reaching too far.
Bear Put Spread Specifics
◉◉ Action: Write (“sell to open”)
a lower-strike put and buy
(“buy to open”) a higher-strike
put (usually, but not always,
straddling the stock price).
◉◉ Trade type: Net debit; you
always pay out to set up the
trade.
◉◉ Maximum loss: The amount
you pay to set up the trade.
This occurs when the stock
ends above the strike of your
higher-strike put.
◉◉ Maximum profit: The
difference between your two
strike prices, minus your initial
debit. This occurs when the
stock ends at or below the
strike of your lower-strike put.
◉◉ Break-even price: The higher
strike price minus your initial
debit.
Let’s walk through an example.
Suppose a retail company that sells
poorly made, overpriced products is
trading at what you deem a too-high
$30 a share. The stock appears ripe
for a decline, so you set up a bear put
spread, buying $33 puts, which cost $5,
and writing $28 puts, which pay $2.50,
for a net debit of $2.50 per share. Since
$5 separates the two strikes, the most
you can make is $2.50 per share ($5
minus the $2.50 debit), or double your
investment. The most you can lose is
$2.50 per share as well. Your break-
even price is $30.50, and if the stock
falls below $28 by expiration, you
make the full 100%; if it trades above
$33, you lose your full investment.
By choosing your strikes carefully
and making sure the options pay a
reasonable price, you’ve set up a bear
put spread with strong profit potential.
To be especially defensive, you could
set up a bear put spread with strikes
above the current share price: In this
case, you could buy $36 puts and write
$32 puts on the $30 stock. As long as
shares stay below $32, you’ll earn the
full amount possible on your spread.
However, defensive spreads usually
don’t pay much. On the flipside, an
aggressive bear put spread would
use strike prices below the current
share price, such as buying $28 puts
and writing $25 puts. The $30 stock
needs to fall below $25 for you to earn
the full profit, but the profit will be
handsome.
Usually, we’ll write moderately minded
bear put spreads, similar to our first
example.
Bear Call Spreads Table 1
Yes, Fools, you can use call options to Stock Buy $33 Write $28 Bought Written Total
make outright bearish investments. Price at Call for $2; Call for $4; Call Call Spread
Bear call spreads have a compelling Expiration Value at Value at Profit at Profit at Profit at
draw: You start with a net credit to Expiration Expiration Expiration Expiration Expiration
your account. To set one up, you buy $28 or $0 $0 ($2) $4 $2
calls at a higher strike, and then write lower
calls at a lower one. (Since lower- $29 $0 $1 ($2) $3 $1
strike calls are always worth more, $30 $0 $2 ($2) $2 $0 (break
you always start this trade with a net even)
credit.) As with all spreads, one side
$31 $0 $3 ($2) $1 ($1)
of your trade protects against the
$32 $0 $4 ($2) $0 ($2)
other, capping your risk.
$33 $0 $5 ($2) ($1) ($3)
Bear Call Spread Specifics $34 $1 $6 ($1) ($2) ($3)
◉◉ Action: Buy (“buy to open”) Every price - - - - ($3)
calls with a higher strike, and above $34
write (“sell to open”) calls with
a lower strike. To be most defensive, you would use the hedge- or short-minded investor,
strike prices above the underlying bear call spreads have merits.
◉◉ Trade type: Net credit; you’re share price, or both out-of-the-money.
always paid to set up the This way, even if the stock goes up,
Bearish Calendar Spreads
trade. as long as it stays below the lower of Calendar spreads are also called “time
◉◉ Maximum loss: The difference the two strikes, the spread will end spreads,” because you’re using different
between your two strike profitably. Aggressive bear call spreads expiration dates on your two trades.
prices, minus your net credit. are rare (since bear put spreads work Selling a near-term put (expiring in a
better for strong bearish cases), but few months) and buying a longer-term
◉◉ Maximum profit: Your original these are initiated with both strikes one (expiring at least a few months
net credit. below the share price. later), both with same strike price, sets
up a bearish put calendar spread. The
◉◉ Break-even price: The lower Bear call spreads are popular because idea is that the near-term put you write
strike price plus the credit they start with a net credit, but they will lose value more rapidly than the
received. have disadvantages compared with longer-term put you buy, financing
Let’s assume you set up a bear call bear put spreads. First, if you write the purchase of your put, especially
spread on the same $30 retailer from an in-the-money call (which your if you’re able to write near-term puts
our bear put spread example. You buy lower-strike call often is), an early a few times while waiting for your
calls at $33, which cost you $2, and exercise will derail your strategy. longer-term puts to pay off. But this
then write calls at $28, which pay you Second, calls tend to hold time value strategy comes with a caveat.
$4; your net credit is $2 per share. If longer than puts. A bear call spread You’re generally hoping that the stock
the stock ends below $28, both calls will not respond as quickly as a bear or index holds up long enough for
expire and you keep the $2 per share. put spread to a favorable move in the your written puts to expire and then
If it rises above $33, you’d close both stock, thus forcing you to wait longer declines, making your purchased
calls before expiration, and your cost before you can close the trade for puts profitable. In other words, you’re
would be the difference between your desired profit. Finally, bear call bearish, but you want some time before
the two strikes, or $5. Given your $2 spreads still require buying power. prices decline — so perhaps you see
credit, you’ve lost the maximum $3 The difference between your strikes a catalyst for decline on the distant
per share. See Table 1 at top right for minus the credit you receive will be horizon. That said, if the underlying
the details. locked out of your account. Still, for investment falls rapidly, your long-term

options.fool.com Options U: Masters Motley Fool Options 11

puts will have more value than the ones
you wrote, and you could close both for
a net profit.
Bearish calendar spreads using puts
can be set up for very little cost. Your
expectation should be that most times,
you’ll lose your entire investment, but
when it does work out, it will more
than compensate for every loss. If your
net cost for a put is $0.50, when the
stock falls sharply, your profits will soar.
Bearish Calendar Spread
(Using Puts)
◉◉ Actions: Write (“sell to open”)
puts expiring soon, and buy
(“buy to open”) the same strike
puts expiring much later.
◉◉ Trade type: Net debit. You pay
to set up the trade.
◉◉ Maximum loss: Your net debit.
12 Motley Fool Options Options U: Masters options.fool.com
◉◉ Maximum profit: Once your
written puts expire, your
potential profit on the puts you
bought is unlimited, until the
stock goes to zero.
◉◉ Break-even price: N/A.
Building upon what you’ve learned,
a calendar spread that uses the same
strike prices and different expiration
dates is called a horizontal spread.
One that uses different strike prices
and different expiration dates is called
a diagonal spread. For example, you
might write near-term puts at a higher
strike for a larger payment and buy
long-term puts at a lower strike to set
up a diagonal bear put calendar spread.
(Yes, it’s a mouthful!)
Follow-Up on Your Trades
You usually want to close the vulnerable
leg of your spread soon before
expiration to avoid it being exercised.
Furthermore, if the underlying stock
makes a dramatic move that makes one
side of your trade especially profitable
(generally, the written side), you can
consider closing it early and writing
new options at a more advantageous
price for another payment. A dramatic
move that earns you much of your
spread’s potential profit long before
expiration may merit closing the trade
out entirely, although in many cases
you’ll need to wait until right before
expiration to achieve your maximum
profit. A dramatic move against you
may severely limit your potential
responses, other than to salvage what
value still remains.
There are many other follow-up
possibilities with spreads – including
turning them into entirely different
option strategies. We’ll have a guide
devoted solely to the topic ahead.
Lesson 5
Neutral Calendar Spreads
Imagine if Back to the Future had been about options ...
Why Use Neutral Spreads?
◉◉ To earn a profit on a range-
bound or flat stock or index.
◉◉ To earn a high percentage
return on your capital at risk.
◉◉ To have limited risk, even if the
stock or index moves sharply.
If Back to the Future had been about
options, Michael J. Fox and Christopher
Lloyd would have put their heads
together over calendar spreads.
Calendar spreads are also called “time
spreads,” because in essence you’re
selling time.
How so? You write an option that
expires in the near future, and you
simultaneously buy the same strike-
price option with a later expiration
date. Since you’re using the same strike
price, but different expiration dates, this
is also called a horizontal spread.
The “spread” you’re looking to
capitalize on is an eventual difference
in time value. The near-term option
you write should lose its time value
soon (paying you in the process), but
the option you purchase that expires
later (and which protects the obligation
of your written option) should retain
much of its time value — allowing you
to sell it as your first option expires,
resulting in a profit overall.
You usually close the entire spread as
the earlier option nears expiration.
Beyond neutrality, you are not
predicting the movement of the
underlying investment, which can
options.fool.com Options U: Masters
travel within a certain price range and
still allow you to profit. You’re just
looking to earn time value with limited
risk.
Calendar Spread Details
◉◉ Actions: Write (“sell to open”)
an at-the-money or near-
the-money option typically
expiring in a few months. Buy
(“buy to open”) an option at
the same strike price with an
expiration date typically two to
three months later than that of
the written option.
◉◉ Trade type: Net debit. You pay
to set up the trade.
◉◉ Desired outcome: The option
you write expires worthless
or with little value; you close
it and the later-dated option
(which retains more of its
value) simultaneously, keeping
the difference in time value
erosion as your profit.
◉◉ Maximum loss: The debit you
pay to set up the trade. If the
underlying investment moves
too sharply in either direction,
the time value difference
between your two options will
diminish (as both options turn
into intrinsic value), leading to
losses that can’t exceed your
initial debit.
As the “time spreader” setting up this
trade, you should be mindful that
volatility could alter the dynamics of
the position. If the share price becomes
more volatile, your longer-term option
could increase in price more than you
anticipated, increasing your profit.
However, if volatility declines, your
long-term option may lose more time
value than you anticipated, lowering
your profit. You generally want
consistent or modestly increasing
volatility when you set up a neutral
calendar spread.
Strategy Example
Using the SPDR S&P 500 (NYSE:
SPY) ETF, let’s set up a calendar spread
example. The S&P 500 ETF trades
near $163 as I write this; let’s say you
believe it will stay near that price for a
few months (in our example, well into
June).
So …
◉◉ You write (“sell to open”) $163
calls that expire June 22, for
which you’re paid $2.50 per
contract.
◉◉ You simultaneously buy (“buy
to open”) the same number of
$163 calls that expire Aug. 17,
which cost you $4 per contract.
◉◉ Your net debit is $1.50 per
spread ($150).
Table 1 on the next page shows how
your trade could work out as expiration
nears on the June 22 written calls,
which is when you would typically
close the spread.
If the index remains around $163, this
spread pays a very healthy return on
your $1.50 at risk. If the ETF ends the
Motley Fool Options 13
June expiration at $163, the spread Table 1
more than doubles your money when
you close it for $3.20. If the S&P 500 Index Value Written Value of Purchased Spread
wanders (as it likely will), you still earn Price of June Call Profit/ August Call Profit/ Profit/
a strong return on your capital in a at June Written (Loss) Purchased (Loss) (Loss)
price band from $160 to $167. And if Expiration Calls Calls (Est.)
the ETF moves far beyond those prices, $159 $0 $2.50 $1.30 ($2.70) ($0.20)
the most you can lose is your original $160 $0 $2.50 $1.80 ($2.20) $0.30
$1.50 per spread. $161 $0 $2.50 $2.30 ($1.70) $0.80
Imagine SPY falls to $150 by June; $162 $0 $2.50 $2.80 ($1.20) $1.30
both options in your spread would $163 $0 $2.50 $3.20 ($0.80) $1.70
be essentially worthless. If SPY $164 ($1) $1.50 $3.80 ($0.20) $1.30
soared to $180, both options would
$165 ($2) $0.50 $4.50 $0.50 $1
consist almost entirely of intrinsic
value, canceling each other out and $166 ($3) ($.50) $5.20 $1.20 $0.70
eliminating much of the $1.50 you $167 ($4) ($1.50) $6 $2 $0.50
invested; your August options would $170 ($7) ($4.50) $8.30 $4.30 ($.20)
have a little time value, reducing
your loss a bit. So, extremes are not Follow-Up Trades a calendar spread and the underlying
this strategy’s friend, but small price investment moves sharply higher, you
As your written calls near expiration, could close the puts you had purchased
moves still leave room for a good
you should “buy to close” them unless to recoup some value. When a neutral
profit.
they’re a sure bet to expire. If you still calendar spread ends around breakeven
Calls or Puts? believe in the trade, you might then or offers a small profit or loss, and your
write new calls that expire in only a opinion hasn’t changed, it’s usually
You can see in our table that the month (July, in this case), keeping
trade is slightly more profitable as easy to continue the strategy with new
your purchased August calls longer. trades.
the ETF moves above the $163 strike Otherwise, you should “sell to close”
price, compared with slightly below the long calls as your written calls The Bottom Line
it. This is because our example uses expire. If the underlying investment on Calendar Spreads
call options; your purchased call will hasn’t wandered much, you’ll be left
have more value if the index is higher. When neutral calendar spreads are
with a profit. Either way, you should be
You would consider using put options profitable, the return on investment
prepared to close the entire spread by
to set up a calendar spread if you can be large. However, the underlying
the expiration of the first option if you
were more bearish than bullish (but investment needs to stay in a
don’t want to extend the strategy.
still expected the market to remain reasonable range for this type of spread
generally flat), because a put calendar If something drastic happens before to profit; if the underlying ETF or stock
spread will perform a bit better than then — say, the underlying investment moves dramatically in either direction,
a call calendar spread when prices drops 7% — you might close your you have to be ready to forfeit your
decline. A careful investor will look purchased calls early to capture as whole investment. So, when you think
at current call and put prices and much value as you still can, thus a share price is going nowhere and you
weigh market sentiment to decide shrinking your loss, while letting your want returns from it anyway, consider
whether to use calls or puts. In most written calls expire (assuming you can setting up a neutral calendar spread
environments, though, calls hold hold them on margin). However, even with money you can afford to lose.
value longer, so call calendar spreads if you do nothing, your loss is still You won’t lose more than the initial
are preferable (because you want the capped at the initial debit you paid to cost, and you may earn a strong return
option you buy to retain as much set up the trade ($1.50 in our example). thanks merely to time — even while the
value as possible). Conversely, if you use puts to set up underlying investment earns nothing.

14 Motley Fool Options Options U: Masters options.fool.com

Lesson 6
Synthetic Shorts
A Foolish investor should only go short carefully
Feeling bearish? If you’re looking
to profit when stock prices slip,
there’s a way to use options to mimic
shorting a stock – but with distinct
advantages. To set up this “synthetic
short” position, you sell a call option
and simultaneously buy a put option,
using the same strike price and
expiration date for each. Unlike a
covered call strategy, in this case you
do not own the underlying stock, so
when you sell (or write) the call, it’s a
“naked” call.
That means, just as when you short a
stock outright, your potential losses
are unlimited with synthetic shorts
– so this is a risky strategy. But your
potential profits are hefty, and the
strategy provides advantages when
compared to traditional shorting.
First, you don’t need to borrow shares
of a stock to short it when using
options – often, the stocks you want
to short most are the most difficult
to obtain for a traditional short sale.
Second, the amount of money you
need to risk up front is typically
much smaller with a synthetic
short, given the leverage provided
by options. Third, unlike when you
short a stock outright, you don’t
need to cover any dividend payments
yourself. Finally, both opening and
closing a synthetic short can be done
quickly, while the traditional shorting
method sometimes involves a lot of
waiting. To get a handle on how this
strategy works, let’s run an example.
options.fool.com Options U: Masters
Sell a Naked Call,
Buy a Put
Brave soul that you are, let’s say you
want to bet against one of Warren
Buffett’s recent investments. Volatile
Goldman Sachs (NYSE: GS) has
jumped to $100 per share, and you
believe there’s profit to be had by
shorting it over the next few months
(remember, shorting usually involves a
narrow time frame). Borrowing shares
to short is difficult, and the stock pays
nearly a 2% dividend – which you
don’t want to cover yourself – so a
synthetic short is your best route.
Although your shorting thesis only
covers a few months, you want to use
LEAP options so you have more time
to be correct if need be. Choosing
options that are as close to Goldman’s
current share price as possible, you
simultaneously sell the January 2011
$100 calls (which will pay you $32
each) and buy the January 2011 $100
puts (which will cost you $29). This
results in a $3 per share credit to you.
You’re now effectively short Goldman
Sachs – and Buffett (how do you even
sleep at night?).
In the ideal situation for you,
Goldman declines 20% or more over
the next few months and pushes both
your calls and puts toward sizable
profits. Your thesis has played out, and
you should close your position – both
options – profitably while you can.
The terrifying outcome (here’s that
risk we mentioned) would be if
Synthetic Shorts
Synopsis
◉◉ To replicate shorting a
stock with options, you sell
a naked call and buy a put
option simultaneously.
◉◉ For a straight synthetic
short, you sell a call and
buy a put with the same
strike price, the one that
is as close to the current
share price as possible.
◉◉ Use the same expiration
date for both call and put.
◉◉ Be careful – selling naked
calls is risky! The higher the
stock goes, the greater your
potential loss.
◉◉ Use LEAPs so you have
more time to be proven
right.
◉◉ Once you have your desired
profit, close the options
– shorts usually involve a
narrow time frame.
◉◉ To take on less risk, “split
the strikes” and use a
higher call strike price.
◉◉ Consider synthetic shorts
on indexes (like SPY) as a
portfolio hedge.
◉◉ For less risk shorting with
options, simply buy puts
and forego writing naked
calls.
Motley Fool Options 15
Goldman soared. Your options would
show large losses, and you would
either need to take your lumps and
close them or wait and hope for
Goldman to fall. Because you have
naked calls, by their expiration you’ll
be required to buy Goldman stock at
the going market price if it sits above
$100 per share, and then deliver the
shares at $100 per share for an instant
loss – just as if you’d shorted the stock
outright.
Another risk with an underwater call
option is that it could be exercised
early, forcing you to buy the stock and
deliver it sooner than you wanted. It’s
rare that an option is exercised early,
but – especially when you don’t own
the underlying shares – you need to be
aware that it could happen. You also
need to maintain enough buying power
to cover your naked call obligations,
and those broker requirements will
be updated daily if the stock increases
against your position.
Splitting the Strikes
If this example sounds too risky, you
can add a little breathing room to your
16 Motley Fool Options Options U: Masters options.fool.com
synthetic short by “splitting the strikes.”
To do this, you still sell your naked
calls and buy your puts with the same
expiration date, but you use different
strike prices.
For example, rather than using the
$100 strike price, assume you sell the
January 2011 $115 calls on Goldman
for $24 each and buy the $85 puts for
$24 each. This gives you a sleep-aiding
15% window before your naked call’s
strike price is hit. The lower strike on
the put does make it more difficult
to ultimately profit from the stock’s
decline, but in the short term, the $85
put will move nearly as much as the
$100 put when Goldman declines.
So, it’s still attractive, and you’re still
effectively short Goldman, but with
less risk.
Just Buy the Puts
Remember, you can also invest against
a stock by simply buying put options
on it and foregoing selling naked calls
to finance your put purchase. Sure, you
need to come up with all the money
to buy the puts yourself, and if you’re
wrong on the trade, most or all of that
money will be lost. But that’s the most
you can lose with a put purchase, so
your risk is known. You won’t have to
worry about the potentially unlimited
losses that a naked call entails.
The Foolish Bottom Line
The market’s long-term trend remains
up, so a Foolish investor should only
“go short” carefully and in special
situations. Business is Darwinian by
nature, companies come and go every
year, and synthetic shorts provide a
way to invest against the losers. We
prefer to short companies with high
debt, weak or no profits, few growth
prospects, a low CAPS score, and
inflated valuations.
A synthetic short is also well-suited for
shorting a market index to hedge your
portfolio. Naturally, an index doesn’t
present as much upside risk as an
individual company. In closing, while
synthetic shorts are as risky as selling
short outright and shouldn’t be taken
lightly, the advantages of the strategy
over straight shorting earn it a rightful
place in our toolbox.
Lesson 7
Synthetic Longs
Take a bullish position without spending capital today
Why Use Synthetic Longs?
◉◉ You believe a stock is headed
higher and want to profit
without paying cash out of
pocket.
The synthetic long option strategy
works nearly the same as owning the
underlying stock outright — except
you don’t need to pay up front.
Usually, you’ll set up a synthetic long
on a stock if you foresee a strong
catalyst for appreciation in the next 24
months or so. As the stock price goes
up, your option position gains value
along with it, sometimes to a much
greater degree.
Buy Calls, Sell Puts
To set up a synthetic long, you sell
to open puts, and use the proceeds
to buy to open calls, typically at the
same strike price, and always at the
same expiration date. On the call
options we buy in this strategy, our
upside potential is unlimited; on the
put options we sell, the worst-case
scenario is we end up buying the
underlying stock at a price of our
choosing. This makes the synthetic
long an especially attractive trade for
bullish investors.
Bullish on a Stock?
Go Synthetic Long!
For a true synthetic long, the calls you
buy and puts you sell will have the
same expiration date and strike price,
although there are variations that we’ll
discuss below.
options.fool.com Options U: Masters
When you buy a call, you believe
that the underlying stock is going to
appreciate considerably over the life of
your option. If it does, the call usually
gains value dramatically. If the stock
does not appreciate, however, your call
will move toward expiration with less
and less value, finally ending with little
or no value.
That is always the risk of buying
options. You need to be correct by the
expiration date or the option won’t
maintain value, and you could lose
your whole investment. This potential
loss is much easier to stomach,
though, if you use income from a put
sale to buy your calls. This is exactly
what we do to set up a synthetic long
position.
Imagine you want to set up a synthetic
long on a $12.50 stock. You would
sell to open the $12.50 puts and buy
to open an equal number of $12.50
calls, both with the same, most distant
expiration possible. Setting up the
trade should cost you virtually nothing
out of pocket, and the way the two
options will move in tandem as the
stock moves, your option position’s
value will mirror the stock’s value all
the way up and down.
Splitting the Strikes
Setting up a synthetic long with
identical put and call strike prices
near a stock’s current share price is
the norm (because you’re looking
to approximate a stock purchase
today), but it may not be the most
comfortable choice for you. For
more downside protection, you may
consider “splitting the strikes” as you
set up a synthetic long. In this case,
you still use calls and puts that expire
during the same month, but you use
different strike prices.
Let’s say you want to set up a synthetic
long on a $12.50 stock. But you decide
to write the $10 put options instead of
the $12.50 puts. The $10 puts pay you
$2.50 per share. With that income,
you can then buy the $15 call options
(instead of the $12.50 calls) for about
$2.80 per share. The net cost is the
same — just $0.30 per share — but
you have more downside protection
when you split the strikes this way. If
the stock declines, you don’t need to
buy it until it is $10 or lower, and your
net start price will be $10.30.
What do you sacrifice? You now need
the stock to appreciate by a greater
degree (compared to buying the
$12.50 calls) by expiration for your call
options to appreciate meaningfully or
at all.
When to Close
a Synthetic Long
If all goes well, the underlying shares
will appreciate long before your
options near expiration, at which
point — based on the valuation of the
stock and the amount of time left in
your options — you should consider
taking your profit in your call options
(unless you prefer to exercise them in
order to own the stock at your call’s
strike price). At the same time, your
Motley Fool Options 17
put options are on the path to expire
for the full cash payment.
Usually, we’ll use synthetic longs to
profit from the options themselves
over the course of our investing thesis
— typically, around 18 to 24 months.
But sometimes we will exercise the
calls and turn them into a stock
position if the options are successful.
18 Motley Fool Options Options U: Masters options.fool.com
On the flip side, when the position
works against us and we need more
time for our thesis to materialize, we’ll
be ready to buy the shares and hold
them. As long as you’re ready to own
the stock, a synthetic long is no more
risky than buying a stock on day one,
but is a cash-free way to profit on a
stock’s gain.
The Foolish Bottom Line
When you’re bullish on a stock and
want to invest without spending capital
today, a synthetic long position is a
sensible alternative. It can reward you
with handsome profits on two options
at once, with unlimited upside on the
call options — or net you shares of a
stock you should be happy to buy.
Lesson 8
Strangles
Profit if a stock makes a severe move in either direction
Why Use Strangles?
◉◉ You buy (“buy to open”) a
strangle to profit on a sharp
move in a stock, whether up or
down.
◉◉ You write (“sell to open”) a
covered strangle to profit when
a stock stays within a wide
range — or, if it doesn’t, to
get a better buy price on new
shares or a higher sell price on
existing shares.
A strangle is similar to a straddle:
You’re using call and put options on
the same underlying stock, typically
with the same expiration date. As with
a straddle, you buy a strangle to profit
on high volatility. Inversely, you write
a strangle to profit when a stock stays
within a predetermined price range or
is relatively stable. The bonus: Writing
a strangle offers more flexibility than
writing a straddle because you “split
the strikes” — set it up with a different
strike price on your calls than on
your puts — and you use strike prices
that are “out-of-the-money,” or well
above or below the stock’s current
price, giving you more room to profit.
Writing a covered strangle is actually
no different than owning a stock
and writing covered calls on it to sell
higher, and simultaneously writing
puts to potentially buy more shares
lower. You’re combining these two
common strategies, generating higher
options premiums on a trade.
Let’s take a look.
options.fool.com Options U: Masters
Setting Up the Trade
Here’s how to initiate a strangle (no
necks necessary):
◉◉ To buy a strangle: Buy to
open an equal number of calls
and puts on a stock, typically
each out-of-the money by one
or two strike prices, with the
same expiration date.
◉◉ To write a covered strangle:
Sell to open puts and calls,
also out-of-the money
and usually with the same
expiration date. However,
the number of puts you write
is dependent on how many
additional 100-share blocks
you’d like to potentially buy,
and the number of calls you
write will depend on how many
100-share blocks you already
own and would be willing to
sell at a higher price. Ideally,
you own a 50% allocation and
would happily buy 50% more.
◉◉ To place a strangle trade:
Most brokers have a special
option order-entry page for
strangles.
Usually, you write (or if it’s a buying
strategy, buy) both sides of your
strangle at the same time, but
sometimes you can increase your
option payments by “legging into” the
strategy — setting up one side of your
trade at a different time than the other.
For example, you might write calls on
your targeted stock when it’s near the
Recap:
Straddle vs. Strangle
◉◉ Straddle: Use an equal
number of puts and calls,
on the same stock, with the
same expiration date and
strike price (one “at-the-
money”).
◉◉ Strangle: Use an equal
number of puts and calls,
on the same stock, usually
with the same expiration
date but with differing
strike prices (both “out-of-
the money”).
high end of your expected range and
then write puts when it’s nearer the
low end. However, since nobody can
predict future prices and you don’t
want to miss one side of your trade,
usually you set up both legs of your
strangle simultaneously, typically
doing so when the stock is somewhere
between the strike prices on your calls
and puts.
Buying a Strangle
Buying a strangle (also called a long
strangle) is a way to profit if a stock
makes a dramatic move in either
direction. Since you’re buying out-of-
the money options that have relatively
small value attached, your cost can
be marginal. Your potential gains are
unlimited, but it’s easy to lose most or
all of your investment.
Motley Fool Options 19
As an example, let’s assume a volatile
stock is trading at $12.50. You believe
it will be exceptionally volatile in
either direction, perhaps on some key
news event. You can purchase a $10
put expiring in nine months for $1.00,
and purchase a $15 call expiring the
same time, also for $1. If you buy one
contract of each, you’ve invested just
$200 plus commissions to enter the
strategy, showing a frequent advantage
of a long strangle: low costs to initiate.
However, because your options are
far out-of-the money (or far from the
strike prices), the stock must make a
dramatic move in either direction for
you to ultimately make money, either
falling below $8 or rising above $17.
Because you paid $2 for your options,
your $10 puts don’t end profitably
unless the stock falls below $8, and
vice versa on the call side. If the stock
doesn’t move much, your options
will steadily lose value and expire
worthless if you don’t sell early.
Buying a strangle works best if a stock
makes a meaningful move quickly.
This way, your calls or puts will see
a significant percentage gain long
before expiration, offsetting the loss
on the other side of your strangle,
and you can book an early profit by
selling both (or sell the profitable side
and hold the losing side if you believe
the stock will snap back). But it’s not
easy. Using out-of-the-money options
makes buying a strangle cheaper than
buying a straddle (which uses more
expensive at-the-money options), but
it also means you’re more likely to lose
your full investment unless you get
extreme volatility soon.
It follows, then, that writing a strangle
puts the odds in your favor.
Writing a Covered Strangle
Writing a covered strangle (also called
a short covered strangle) is a way to
20 Motley Fool Options Options U: Masters options.fool.com
profit on a stock that you own and
would be willing to either buy more
of lower or sell your existing shares
higher. Writing strangles can be
superior to writing straddles because
splitting the strike prices provides
more flexibility and room for profit.
The options won’t pay as much as a
straddle, but the stock has more room
to roam.
For example, say you own shares of
Motley Fool Options recommendation
Western Union (NYSE: WU), and
you’re willing to buy more if the stock
declines meaningfully; or, you’re
willing to sell your existing shares
higher. With the stock recently around
$16, you could write the $15 puts
expiring in five months for $0.65, and
write $17.50 covered calls expiring at
the same time for $$0.60, collecting
$1.25 in total options premiums (or
nearly 8% of the current share price).
Consider the possible outcomes:
◉◉ Western Union ends the
expiration period anywhere
between $15 and $17.50: You
keep the $1.25 per share the
options paid you, and keep
your shares, too, and can
consider writing a strangle
again.
◉◉ Western Union increases
above $17.50 by expiration:
You’re on the hook to sell your
existing shares for a net $18.75,
including the $1.25 the options
paid you.
◉◉ Western Union falls below $15:
You’re obligated to buy new
shares at a net $13.75, again
including the $1.25 the options
paid you. You’ve now doubled
your position in Western Union,
lowering your cost basis along
the way.
Of course, in most cases you could
also “buy to close” your options early
or right before expiration, and still
have a profit on the combined options
trades assuming the stock hasn’t
moved too dramatically — in this case,
as long as it’s between $13.75 to $18.75.
As you can see, a covered strangle can
give you an exceptionally wide profit
range while paying healthy income.
Whenever you write puts, you need to
be confident in the stock that you’re
exposing yourself to and ready to buy
it (again, it’s best to write strangles
when you own half an allocation in
a stock and would happily double
it). And whenever you write covered
calls, you must be ready to sell your
existing shares if they increase in
price. However, given how much the
two combined options pay you with a
strangle, you have more flexibility —
or possibility — to close your options
early if you wish, keep your shares,
and still have a profit.
The Pluses
of Writing Strangles
The combined payment you receive
from the options you write, added
to the strike price on both sides of
your trade, tells you the potential sell
price on your existing shares, or buy
price for more shares — and creates
your range in which to profit on
the options alone. A $10 stock with
a strangle that pays $1 on each side
gives you a range of $8 to $12 in which
to profit. Typically, a written strangle
range will be 10% to 20% on either
side. To write an attractive strangle,
generally follow our numerical
guidelines provided for writing puts
and writing covered calls, since that’s
all you’re really doing on the same
stock. Even owning a 50% stake,
the advantage of writing a strangle
includes the potential to capture
meaningful upside up to a point —
almost as much upside (about 75%
or so on average) as if you owned a
full stake in the stock, thanks to the
options payments — while subjecting
yourself to the risk of a full position
only at a reasonably lower average
price.
Follow-Up
on Writing Strangles
The closer to either edge of your
option profit range (with our Western
Union example, $13.75 and $18.75 are
the two edges) that the stock trades
by expiration, the more likely you
are to let one side of your trade be
exercised, either buying more shares
or selling your existing shares, since
your intention was to get the stock
involved on the far edges of your
trade. Meanwhile, one side of your
strangle will always expire for the full
cash gain. If the stock is between your
strike prices, both sides will expire for
a full gain. If the stock hasn’t wandered
too far, but one of your written options
is modestly in-the-money, you may
want to close it before expiration (your
options.fool.com Options U: Masters
trade is still profitable) if you’d rather
set up a new strangle. If the shares
fall sharply, you need to be ready to
buy more and wait. If they soar, you’ll
need to sell anyway and be content
with the profit you booked. As with
writing puts or covered calls, once
you’ve made most of your money (85%
or more), it may be worthwhile to
close the option and write a new one,
later one for a higher payment. Just be
mindful of the obligations tied to both
sides of your strangle.
Writing Uncovered
Strangles
While not owning a stock, some
daring investors write uncovered
strangles when they strongly believe
the stock won’t break above a certain
price. You may not own a $10 stock,
but want to collect $2 in strangle
premiums. As long as the stock is
between $8 and $12 by expiration,
you could close your options, not get
the stock involved, and book a partial
profit. But with a naked strangle, if
the stock soars, your potential losses
are unlimited because your written
calls aren’t covered by existing shares.
We’re unlikely to partake in this risky
strategy without also buying calls to
protect ourselves — it’s not worth
the unlimited risk to collect a limited
premium.
The Foolish Bottom Line
on Strangles
Buying a strangle is a way to profit
if a stock makes a severe move in
either direction — but if it doesn’t,
you risk whatever you invested in the
calls and puts. On the other hand,
writing a covered strangle is a way to
generate option profits on a position
if you already own at least 100 shares,
would be happy to add at least 100
more shares at a lower price, or sell
your existing shares higher. More
flexible than just writing covered calls,
and providing more upside than just
writing puts, covered strangle-writing
provides a wide window for profits on
a strong company that you believe will
stay in a range or slowly trend higher.
Motley Fool Options 21
Lesson 9
Writing Straddles
Increase your profits on a covered-call strategy with a tame stock — as long as you’re
willing to buy more shares
Why Write a Straddle?
◉◉ You believe a stock or index is
going to hold steady or stay in a
tight range.
◉◉ You believe a stock that was
recently volatile will settle
down considerably.
◉◉ You believe the market’s overall
volatility is going to decrease.
Setting Up the Trade
A straddle uses an identical number
of calls and puts with the same strike
price and expiration date on the same
underlying stock or index. You buy
identical calls and puts on a stock to
profit in either direction from volatility,
but you need a sharp and lasting move
in either direction in order to profit
overall. Inversely, writing the calls and
puts is a way to profit from low or
declining volatility. How? Simply by
collecting option premium payments
on either side of a potentially sleepy
position. There are risks, of course, but
let’s start with the basics:
◉◉ Write (“sell to open”) an equal
number of puts and calls on the
same stock or index.
◉◉ Use the same strike price and
the same month of expiration
on both options.
◉◉ The strike price with a straddle
is “at-the-money” — as close to
the current underlying stock or
index price as possible.
22 Motley Fool Options Options U: Masters options.fool.com
◉◉ When you write an uncovered
straddle, you don’t own the
underlying stock, so your risk is
high (more on this in a minute).
◉◉ When you write a covered
straddle, you own the stock,
lowering your risk on one side
of the option trade. Here the
straddle works like a covered
call strategy — but your returns
are potentially goosed with
additional put-writing income,
and you need to be ready to
buy more shares of the stock if
it falls, just like when you write
any puts.
The most you can earn from the
options when writing straddles is what
the options pay you initially.
Uncovered Straddle Writing
When writing an uncovered straddle,
you usually don’t intend to get the
underlying stock involved. You’re just
looking to profit on the value erosion
of the options you write, and you’ll
plan to “buy to close” them (or let
them expire) once you’ve earned your
targeted profit. (Note: You need a
margin account to write an uncovered
straddle.)
As an example, suppose a recently
volatile stock just announced earnings,
and you expect its volatility will now
all but cease. The options still pay well,
though, so you’d like to capture the
option premium as income. The stock
is trading at $25, so you write $25 calls
and $25 puts and get paid $2 for each
contract — that’s $4 total in option
premiums per straddle you set up. This
means as long as the stock ends the
expiration period between $21 and $29
($4 above or below $25), you’ll at least
break even before commissions — and
if the stock is between these prices, you
earn a profit on the trade. (We’ll call
this the “profit range.”)
For example, if the stock ends the
period at $27, the puts you wrote expire
(giving you the full $2 value), and the
calls break even, so the trade pays you
$2 per share overall.
If the stock ends lower in our profit
range — let’s say $23 — the calls expire
and the puts break even, so your profit
is $2 per share overall here, too.
However, outside your profit range,
it’s another story. With uncovered
straddles, you face unlimited potential
losses as the stock rises above $29 per
share, and you facing growing losses
(along with an obligation to buy the
stock and wait for a recovery) the
further it falls below $21.
As Table 1 on the next page shows, the
maximum profit from an uncovered
straddle occurs when the stock
ends exactly at the strike price; you
essentially keep the entire $4 per share
you were paid in this example. Your
total profit declines as the stock moves
away from the strike price in either
direction — which is why you want
minimal volatility whenever you write
straddles.
Take a minute to study the table to Table 1
grasp how this works. As the stock
rises, the naked (or uncovered) calls Ending Call Stock Price at Ending Put Your Total Profit
you wrote increase in value, working Value Expiration Value per Share
against you. As the stock declines, the $0 $20 and lower $5 and higher as ($1) and
puts you wrote work against you, but the stock falls worsening as the
you’ll still profit anywhere between stock falls
$22 and $28, and break even at $21 or $0 $21 $4 Break-even
$29. Remember, you were paid $2 for $0 $22 $3 $1
each call and put, or $4 total. But since
$0 $23 $2 $2
you wrote the options, your desired
outcome is that their value goes to $0, $0 $24 $1 $3
or as low as possible. See Table 1 at $0 $25 (the strike $0 $4
right for details. price)
$1 $26 $0 $3
To help achieve a successful uncovered
straddle, you want the widest possible $2 $27 $0 $2
profit range (in other words, you want $3 $28 $0 $1
to capture generous option premiums). $4 $29 $0 Break-even
In our example, the range is significant $5 and higher as $30 and up $0 ($1) and
— $4 in either direction — assuming the stock rises worsening as the
the underlying stock isn’t exceptionally stock rises
volatile and your options expire in two
to five months (rather than longer). to do so if the trade starts to work options early). The benefits of writing
But remember, the trade creates strongly against you. a covered straddle are two-fold:
unlimited potential losses outside the Given that a steady stock can ◉◉ Your profit can be higher and
profit range. suddenly make a big move for any your profit range wider than
One way to greatly mitigate that risk: number of reasons, it’s risky to write with a mere covered call.
When you write your straddle, use uncovered straddles without this added
protection. However, another route is ◉◉ You have more ways to close
some of your option proceeds to
simultaneously buy far out-of-the- to simply own the underlying stock your options profitably — and
money calls and/or puts, too — with outright. Let’s take a look. still keep your stock if you like.
strike prices at the two ends of your
Covered Straddle Writing Continuing our earlier example, let’s
profit range (for this example, you
assume you want to write a straddle on
might buy $30 calls and $20 puts; or Owning the underlying stock takes
a steady $25 stock — but in this case,
just buy calls to protect you on that away all of the naked call option risk
when writing a straddle. In fact, a you own the underlying shares. You
side and be ready to buy the stock via
your written puts if it falls). Doing covered straddle-writing strategy write $25 calls and puts, getting paid
so, you’ve hedged and “covered” your is basically a covered call strategy $2 each, with the same expiration date.
written straddle, and because buying combined with put writing. The key Since you own the stock, no matter
these options generally costs little, difference with a straddle (as opposed how high it climbs, you’re covered on
you’ll still begin with a net credit to your typical call or put writing) is that side of your trade. Let’s consider
from your option writing and keep that both options start at-the-money, some potential outcomes:
that profit if the stock stays in a now so you’re more likely to see your
slightly tighter range. For example, if options exercised if you don’t close ◉◉ You end up selling your stock
you paid $0.80 total for the protective them. As with a covered call, it’s via the covered calls, but you
calls and puts, your profit range important that you’re ready to sell your keep the $4 option premium
decreases by that amount on either stock if it rises. And as with writing you were paid on the puts and
side of the strike price. If you don’t buy puts, you need to be ready to buy calls, netting a sell price of
protective options initially, be ready more stock if it declines (or close the $29 (compared with just $27 if

options.fool.com Options U: Masters Motley Fool Options 23

 you’d only done a covered call
and not a straddle).
◉◉ The stock declines below
$25. You end up buying more
shares, but at a net $21 given
the total option premiums you
were paid. You’ve added to
your existing stock holding at a
lower price.
◉◉ The stocks holds steady,
around $24 to $26. You can
“buy to close” both the calls
and puts by expiration and
capture much of the profit
while keeping your existing
shares. Nice!
Finally, as an example of the added
flexibility here: Assume the stock
increases to $28 by expiration, and you
decide you want to keep your shares.
Since you were paid $4 per share in
option income, you could close your
calls for $3, let your puts expire, still
have a $1-per-share profit on your
straddle, and keep your stock. If you
had only written covered calls and not
a straddle, you’d need to book a loss
on your calls if you wanted to keep
your stock.
24 Motley Fool Options Options U: Masters options.fool.com
Taking Follow-Up Action
Writing uncovered straddles requires
keeping a close tab on your trade. If
the stock is moving sharply against
you in either direction, you may want
take action to limit your losses. One
way to do so is to close the losing
side of your straddle when the stock
reaches your break-even price. In our
example, if the stock rises to $29, you
might close your call options for a
loss and let your puts go, presumably
to expiration, keeping your overall
losses marginal. If the stock falls,
just be ready to buy it via your puts.
Uncovered straddles don’t usually lend
themselves to rolling forward (to a
later expiration date), rolling up (to
higher strike prices), or rolling down
(to lower strike prices), so you can’t
depend on these defensive follow-up
moves being readily available to you.
As mentioned above, if you defensively
buy out-of-the money protective calls
(and puts, if you like) when you set
up your straddle, your potential profit
on the straddle is lower, but you won’t
need to actively consider follow-up
action.
Writing covered straddles is much less
risky and requires less upkeep, but you
still want to keep a watchful eye on
your strategy, since only your calls are
truly covered. You need to be ready
to accept more shares if the stock falls
below your puts’ strike price. For this
reason, some investors will use a lower
strike price on the puts they write,
providing more leeway — but once
you start to stagger strike prices on
your calls and puts, you’re not using
a straddle anymore, you’re using a
strangle!
The Foolish Bottom Line
on Writing Straddles
In Motley Fool Options, we’re not likely
to write uncovered straddles without
using some protective options as well.
Writing covered straddles, however,
is a sensible way to increase option
profits on a covered-call strategy with
a tame stock as long as you’re also
willing to buy more shares if need be.
With this strategy, you have another
tool to profit no matter what the
market throws your way — in this
case, even if the market goes nowhere.
Lesson 10
Buying Straddles
Set yourself up to profit whether a stock goes up or down
Why Buy a Straddle?
◉◉ You believe a stock or index
will move dramatically, but you
don’t know which way.
◉◉ You believe volatility will
increase in general, so the
value of the options you’re
buying will increase.
◉◉ You want to leverage
potential returns when
the underlying investment
moves meaningfully in either
direction, but limit your risk.
Have you ever thought a stock
was about to make a significant
move – but you didn’t know which
direction it would go? Maybe a big
earnings announcement is looming,
an acquisition is pending, or a stock
has recently soared and could keep
going – or turn at any moment. Most
investors would sit on their hands,
unsure what to do. But if you buy an
option straddle, you can set yourself
up to profit whether the stock goes up
or down, while risking only the small
cost of a few options. This makes
buying a straddle attractive as a bullish
or bearish strategy. In fact, buying a
straddle can be superior to shorting a
high-flying stock outright, since you’ll
profit even if it keeps rising – but also
profit if it finally flames out.
Whether bearish or bullish, this
strategy positions you to make money
as long as the underlying stock is
especially volatile in one direction,
moving at least (as a general guideline)
10% to 30% in the coming weeks or
options.fool.com Options U: Masters
months. The strategy works because
you gain a much larger profit on one
side of your straddle than you lose on
the other (more on that later). And,
to answer your burning question, it’s
called a “straddle” because your calls
and puts sit symmetrically on either
side of the same strike price – while
expiring in the same month, on the
same stock.
Pros and Cons
Before we walk you through an
example, let’s go over what can go
right or wrong. On the plus side,
when you buy a straddle, your profit
potential is unlimited: The more
the underlying stock moves in one
direction, the more you can profit on
that side of your trade. However, as
with any option you buy (as opposed
to writing options), you can lose your
whole investment. In this case, if the
stock stays tightly range-bound, the
options would eventually expire with
little or no value.
The clock also plays a large role, as the
biggest drag on a straddle purchase is
the time-value erosion of the options.
Buying a call and a put, you’ve paid
two option premiums, and with each
passing week their time value erodes
unless the stock’s volatility increases.
If the underlying stock doesn’t make
a significant move in either direction,
your options will steadily lose value.
Plus, the underlying stock needs to
move enough so that one side of your
straddle (either the calls or puts) gains
enough value to offset the losses on
the other side.
A Straddle in Action
Now let’s “straddle up” and see how
the strategy works. Here are the basics:
◉◉ You buy (“buy to open”) an
equal number of calls and
puts on the underlying stock
or index (usually you’ll do this
as a stand-alone strategy, so
you won’t own the underlying
stock).
◉◉ The strike prices of the calls
and puts should typically be
the closest available to the
current price of the underlying
stock or index (“at the
money”).
◉◉ The expiration month on
the calls and puts should be
the same, and usually you’ll
choose an expiration up to four
months ahead if you expect
volatility soon, or six months
or longer if you want more
time. Having more time for
the strategy to work can be an
advantage, but will cost more
up front.
Let’s run an example. Suppose you
believe a stock will move aggressively,
in one direction or another, depending
on the company’s outlook in its next
quarterly report. The shares trade at
$17.50, so you could set up a straddle
that expires in four months, buying
the appropriate $17.50 puts for $1.50
each and $17.50 calls, also for $1.50
each. Your combined cost is $3 ($300).
Motley Fool Options 25
Say management sees business
improving, and the stock runs to
$22.50 the next month. Your calls
are now worth at least $5 each (or
$500), up from $1.50, while the puts
are worth very little — you’re losing
money on them. Overall, though, your
$300 investment is worth more than
$500, a gain of more than 66%. On
the flipside, if management’s quarterly
guidance is weak and the stock falls
to $12.50, your puts are worth at least
$5 each and your calls have little
value. Your profit in this case, as with
the opposite side of the spectrum, is
around 66%.
What if your thesis is wrong, and the
stock stays within a few dollars of
$17.50 for a few months? You’re losing
money on both the calls and puts in
this case, and you might want to close
them (“sell to close”) early to get some
capital back — unless you believe
volatility will increase significantly
and soon. Since you paid $3 combined
for the options, the stock needs to
move at least $3, in either direction,
by expiration for you to at least break
even on the strategy.
Taking Follow-Up Action
Straddles can benefit from more
active management once the position
is in place. There are two ways to
potentially boost your profits while
being defensive:
◉◉ If the price of the underlying
stock increases to the next
26 Motley Fool Options Options U: Masters options.fool.com
higher strike price (compared
to the strike price you used
to set up the trade), you may
want to — depending on the
number of contracts in play
and your commission costs —
close your existing puts and
buy puts at that next-higher
strike price to increase your
profit potential. This is called
“rolling up” the puts.
◉◉ Inversely, if the underlying
stock declines to the next
lower strike price, you could
consider selling your calls and
buying new calls at that next-
lower strike price. This is called
“rolling down” the calls.
While increasing the total cost of
your strategy, these follow-up moves
increase your chance for higher profits
on any subsequent stock move. Roll
up and roll down sparingly, though
— reacting to every zig and zag in the
stock can be a big detriment when
you consider the commissions, option
premium costs, and the fact the stock
could easily swing the other way again.
Closing a Straddle
If your original thesis holds true and
a stock makes a big move, you’ll make
more money on one side of your
straddle trade than you’ll lose on the
other. If you believe volatility is then
subsiding, consider closing (“sell
to close”) both of your positions to
lock in your profit. If you wait until
expiration, you may slowly lose extra
value in your options, or the stock
may reverse on you again.
If your strategy isn’t working in time,
you may want to close one or both
positions early to recoup some capital
and rethink your strategy. Your calls
and puts serve to hedge each other in
the early going. However, both options
will steadily lose value if the stock isn’t
making a large enough move one way
or another.
Finally, although it’s unorthodox, if
you earn a quick profit on one side of
your straddle, you may want to lock in
that profit and let the losing side stay
active. You won’t have much value left
on that side anyway, and if the stock
reverses, you may regain some of the
losing option’s value without risking
the profits you’ve already secured on
the closed side.
The Foolish Bottom Line
on Buying Straddles
If you believe a stock is going to move
significantly — but you don’t know
which way — buying a straddle is a
way to profit in either direction. The
enemy of the straddle-buying Fool is a
stable or merry-go-round stock price,
as the value of your purchased options
will steadily erode unless the stock
makes a lasting, meaningful move in
one direction or another. But if you
expect a big move either up or down,
consider buying a straddle.
Lesson 11
Protective Collars
Protect an existing investment from downside — often without any up-front cost
As we wend our way ever deeper into
the world of option strategies together,
you’ll begin to find creative ways
to protect, leverage, or hedge your
portfolio — often with little downside
risk and at little to no cost to you.
In this guide, you’ll learn how to
use options to protect an existing
investment from downside, often
without any out-of-pocket expenses.
This is called a protective collar —
and when it’s free to you, it’s called a
costless collar.
Protective collars are useful in bear
markets or when you’re uncertain
about a stock’s valuation risk. They
can also be a prudent way to protect
your gains on stocks that have recently
leaped in price, nearing your estimate
of fair value. Let’s explain how collars
work, starting from the beginning.
Insure Your Positions
by Buying Puts
As a long-term investor who remains
committed to your core holdings, you
may be reluctant to sell even if you
see storm clouds on the economy’s
horizon. After all, life is full of ups and
downs, and you can’t simply disengage
when the going gets tough. However,
when it comes to equities, you can
protect your portfolio by purchasing
put options.
That’s right. Purchasing options — not
selling them. When we buy options,
we’re not under any obligation
regarding shares of the underlying
investment.
options.fool.com Options U: Masters
So if we buy puts on a stock we own,
and the puts gain value for us, we’ll
simply sell those puts later for a
profit and still keep our shares of the
underlying stock (assuming we want
to). In other words, when we buy
them, we’re using options as a strategy
on their own, without needing to get
the underlying stock involved unless
we want to.
Now let’s explain buying puts,
specifically. A put option goes up in
value when the underlying equity
or exchange-traded fund declines in
price. So when you buy a put, you’re
basically buying insurance for your
investment. A put gives its owner the
right to sell the underlying investment
at a minimum set price (the strike
price) by a set date (the option’s
expiration date) no matter how far it
falls. In times of uncertainty, buying
puts to protect your key holdings
makes plenty of sense. However, it
can be expensive — and who wants
to shell out piles of cash for insurance
policies that will one day expire?
Enter the costless collar. Using this
strategy, you buy your puts — your
insurance — with funds you receive
from the concurrent sale of call
options, thus saving yourself the cost
of the puts.
The Costless Collar:
Buy Puts, Sell Calls
Assume you own shares of Vanguard
Emerging Markets (NYSE: VWO).
You believe emerging markets will
reward investors in the long run. But
Collar Cheat Sheet
◉◉ Protective collars can be
used to shield against
downside risk in rocky
markets or to safeguard
gains when you’re not
ready to sell — but would
willingly sell at slightly
higher prices.
◉◉ Buy puts and sell calls
with the same expiration
date but different strike
prices (the most attractive
available).
◉◉ You can “cover” all or
some of your shares.
◉◉ The position you’re
protecting usually needs
to decline soon — or
sharply — for puts to pay
off handsomely.
◉◉ Don’t sell calls on stocks
you’re not willing to sell
or that you believe are
grossly underpriced.
◉◉ Typically seek to use
options that expire in
six months or more — or
even Long-Term Equity
Anticipation Securities
(a.k.a. LEAPS) that expire
in 18 months or more. This
allows you to choose more
advantageous strike prices
and be paid more for the
calls.
Motley Fool Options 27
in the intermediate term, you still
see risk to the downside. You want to
protect your investment against a large
decline, just in case.
For our example, assume Emerging
Markets is trading at $21. For a costless
collar, you want to buy puts and sell
(“write”) calls to pay for them. Let’s
say (using real-life quotes available as I
write this) that the $19 strike price put
options expiring in seven months can
be purchased for $2.30 per contract.
Also, the $24 strike price call options
can be sold for $2.10 per contract.
The puts will protect you from a
meaningful decline in the ETF’s price,
and selling the calls to pay for them
means your net cost for the strategy is
only $0.20 per share plus commissions
(remember, you’re paid $2.10 for
selling the calls, and you need to pay
out $2.30 to buy the puts). Nice —
that’s cheap insurance.
28 Motley Fool Options Options U: Masters options.fool.com
The real cost of implementing a
protective collar is limited upside. If
shares of Emerging Markets exceed
$24 by your call option’s expiration,
you’ll miss any upside above that price
and need to sell your shares at $24.
But if the ETF’s price declines over
the next few months, you’ll be glad
you set up the collar. The puts will
provide a profit, and the calls you sold
will expire. Meanwhile, you can keep
holding your shares to await eventual
gains.
Insure Your Positions
and Keep Upside, Too
There is a way to insure your
investment and maintain unlimited
upside potential on at least some of
your shares. Assume you own 600
shares of Stock ABC, bought at $21.
Looking at the options that expire
in 10 months, you can sell $25 strike
price covered calls for $4 per contract.
With the proceeds, you can buy the
$17.50 strike price puts for only $2 per
contract. This means you can protect
all 600 shares by buying six puts, but
you only need to sell three calls to pay
for it — and you still pay nothing out
of pocket.
Your full position is protected against
a sharp decline, and half of your shares
still have unlimited upside potential
since you didn’t sell calls on them.
This type of strategy combines the best
of both worlds: limited downside and
unlimited upside.
The Foolish Bottom Line
Collars can smooth returns, help
hedge your portfolio, protect a
holding, and allow you to ride out a
rough market with more confidence.
They’re not for everyday use, but
they’re useful in situations that merit
protection.
Lesson 12
Stock Repair
Get out of laggard positions at breakeven
Who should use the stock repair
strategy? Someone who is:
◉◉ Down 15% to 25% on a stock
and willing to forego profits to
sell at breakeven.
◉◉ Not interested in averaging
down or holding for the long
haul.
◉◉ Using a margin-approved
account and can write call
options.
At some point, every investor gets
stuck hanging onto a stock that has
declined 20% or so and never seems to
recover. This guide will teach you how
to use options to exit laggard positions
at breakeven. The “stock repair”
option strategy not only recoups your
initial investment, but frees up your
cash for new, stronger buys.
But first, a reality check: Stock repair
does not protect you from additional
downside in the shares you already
own — nor does it offer you a profit
above your break-even price. The
strategy can, however, lower your cost
basis in your losing stock and allow
you to exit the position at breakeven
without introducing any additional
risk.
Setting It Up
To set up a stock repair, for every 100
shares of a losing stock you (woefully)
own:
◉◉ Buy one call option at a strike
price below the current share
price.
options.fool.com Options U: Masters
◉◉ Sell (write) two call options at
a strike price above the current
share price.
◉◉ Use the same expiration date
for the options you buy and
sell.
◉◉ Typically, use options that
expire in 90 days or less.
These option trades result in minimal
or no cash outlay for you because the
call you buy is paid for by the two calls
you sell. Plus, the strategy does not
bring new risk to your stock — your
options are neutral and covered: They
Table 1
If the $30 stock ...
Declines or holds steady at $30
Ticks up a few dollars — say, to
$32.50
Recovers to $35 — bingo!
Soars to $40
Catapults beyond $40
largely cancel each other out, and the
first call option you sell (or write) is
covered by the 100 shares of stock you
already own, while the second call
you sell is covered by the new call you
just bought. Got that? Let’s turn to an
example to show how it works.
Repair That Dog!
Assume you purchased 100 shares of
a stock at $40 per share, and it now
trades at $30. You’re down 25%, lack
hope for the stock’s recovery, and don’t
want to hold your shares any longer.
At the same time, you don’t believe
Then ...
All the options expire, nothing
changes (you just lost on
commissions). You can try again.
You make $2.50 per share on your
$30 call option (because you bought
it at $0 net cost) and by selling the call
for the gain, you’ve effectively lowered
your stock’s cost basis to $37.50. The
calls you wrote expire. You can use the
strategy again.
Your $30 call is now worth $5 per
share, all profit, so your cost basis
in the stock is now $35. You can sell
or close all positions and break even
(commissions aside).
No problem. You are breakeven
on the stock, and your options
cancel each other out. You can close
everything and move on.
All of your positions still cancel each
other out, and you can still sell your
stock at breakeven. You’ve foregone a
profit in the stock, though.
Motley Fool Options 29
there’s high risk left in the stock —
otherwise, you’d simply sell. It seems
your best move to get to breakeven is
to initiate a stock repair strategy.
To start, you purchase a $30 call
option for $2.50 that expires in 60
days. You then sell two $35 call options
for $1.25 each. Your option trades have
paid for themselves. Your positions
look like this:
◉◉ Original stock, bought at $40,
is now $30
◉◉ Buy one $30 call option costing
$2.50
◉◉ Sell two $35 call options for
$2.50 total income
And your possible outcomes are
explained in Table 1 on the previous
page.
As you can see, the stock repair
strategy has three possible results: (1)
no change at all if the stock doesn’t
30 Motley Fool Options Options U: Masters options.fool.com
move or declines; (2) a lower cost basis
if the stock ticks up; or (3) a break-
even sale if the stock cooperates even
halfway.
But what if you set up a stock repair
trade only to change your mind and
turn bullish on your stock again? The
situation is salvageable. Let’s say your
stock returns to $40 on good news,
and you wish to keep owning it. In
that case, you can close all of your
option trades at or near breakeven
(they’ll largely cancel each other out)
and continue to hold the stock.
Choosing Your Strike Prices
In general, this strategy works best
when you’re down about 20% on a
stock. You buy your lower-priced call
options at a strike price that is about
20% below your stock’s start price (or,
at about the current share price), and
you write your two other call options
at the midway point between the
current share price and your stock’s
start price, splitting the two. So, in
another example, if you bought 100
shares of a stock at $50 that is now
$40, to repair it, you’d buy one $40 call
and write two $45 calls.
The Foolish Bottom Line
When you’re down a reasonable
amount on a lagging stock and simply
want out at breakeven, setting up a
stock repair strategy may help you
meet your goal more quickly. The
strategy does not increase or decrease
your risk in owning the stock, but
(unless you close the options early) it
does limit your upside to your break-
even price. You must be happy to just
break even and confident the stock
won’t fall sharply while you wait. To
discuss this strategy or see if it’ll work
on some of your current holdings,
please visit the discussion boards!